Capital Structure
Spring 2022
Chapter 14
Corporate Finance: The Core (4th Edition)
Berk/DeMarzo
§Perfect markets
§Equity vs. Debt financing
§Capital structure, leverage
§Modigliani-Miller Propositions (MM I, MM II)
§Unlevered beta, levered beta
§The relative proportion of debt, equity, and other securities
that a firm has outstanding is called its capital structure
§When corporations raise funds from outside investors, they
have to choose what type of security to issue
§The most common choices are financing through equity
alone, or through a combination of debt and equity
§Financing a Firm with Equity
§Consider the following project
§With a risk-free rate of 5% and an appropriate risk premium
of 10%, what is the project’s NPV?
§Financing a Firm with Equity
§Expected cash flow = ½($1400+$900) = $1150
§NPV = -$800 + $1150/1.15 = $200
§The project has positive NPV
§If this project is financed with equity alone, equity holders will
receive all of the future cash flows, the PV of which is $1000
§Thus, the firm can raise $1000 by selling the equity in the firm
§Financing a Firm with Equity
§Since there is no debt, cash flows of unlevered equity are
equal to those of the project
§Expected return on unlevered equity is 15%, which equals the
risk of the project
§Financing a Firm with Debt and Equity
§Suppose that the entrepreneur decides to borrow $500 at the
risk-free interest rate of 5% per year
§Financing a Firm with Debt and Equity
§With perfect capital markets, the total value of a firm should
not depend on its capital structure (Modigliani and Miller,
1958)
§Because the cash flows of the debt and equity sum to the cash
flows of the project, the combined values of debt and equity
must equal $1000
§The value of the levered equity is $500
§The Effect of Leverage on Risk and Return
§Is the appropriate discount rate still 15% for the levered
equity?
§The Effect of Leverage on Risk and Return
§Returns to equity holders are very different with and without
leverage, and higher risk for the levered equity result in a
higher required return of 25%
§The Effect of Leverage on Risk and Return
§Leverage increases the risk of equity even when there is no
default risk
§While debt may be cheaper when considered on its own, it
raises the cost of capital for equity
§The average cost of capital with leverage is same as for the
unlevered firm
